Assignment -3 IAS-37 – Provision & Contingencies

FAR-II Basic Concept Practice

Provision, Contingent Liabilities & Contingent Assets IAS-37

Note-1
Provision is a liability of uncertain timing or amount.
Liability is a present obligation arising from past events, the settlement of which is expected to result in an
outflow of resources.

Examples of Provisions
Provision for taxation
Provision for gratuity
Provision for dismantling
Provision for litigation
Provision for warranty etc

Difference between a provision and liability:

Provision Liabili
ty
Here timing or amount is uncertain (example Here timing or amount is not normally
of a court case by a debtor, warranty uncertain (trade payable and accrual of
obligation etc.) expenses)

When to recognize a provision (means incorporation in the Financial statement) [Para 14]
1) There is a present obligation as a result of past events.

Obligation may be
Legal Constructive
That derives from a contract or legislation or That derives from entity’s action that create
operation of law (court decision) valid expectations among the interested parties
that entity will discharge those responsibilities
(Example below)

2) There is a probability of outflow of the resources

Although timing or amount is uncertain but a reliable estimate can be made
3)
 If all the above conditions are fulfilled, recognize a provision.
Example-1
Zee Ltd owned a road tanker that overturned in December 20X3 during a bad rain
storm. The tanker spilled its contents thus contaminating a local river. Zee ltd has never
before contaminated a river. Zee Ltd has no legal obligation to clean the river, has no
published policies as to its views on the rehabilitation of the environment and has not
made any public statement that it will clean the river. It intends to clean-up the river
and has been able to calculate a reliable estimate of the cost thereof.

Required:
Explain whether or not Zee Ltd should recognize a provision in its statement of
financial position as at 31st December 20X3.

Measurement of Provision [Para 36]

The amount recognized as a provision shall be the best estimate at the reporting date.
The best estimate of the amount of an obligation is the amount that an entity would pay to settle
the liability.
When making these estimates, management should consider:
Previous experience:
Similar transaction:
Possibly expert advice: and
Events after the reporting period. (IAS-10)

Note-2

Example-2
Sahiwal Manufacturing has sold 10,000 units in the year. Sales accrued evenly over the year.

It estimates that for every 100 items sold, 20% will require small repairs at a cost of
Rs. 100 each, 10% will require substantial repairs at a cost of Rs. 400 each and 5% will
require major repairs or replacement at a cost of Rs. 800 each. On average the need for
a repair becomes apparent 6 months after a sale.

Closing provision?
A provision will be required for the sales in the second six months of the year because
the repairs necessary in respect of the sales in the first six months would have been
completed by the year end.
 Note-3

Future Events [Para 48]

When calculating the amount of the provision, expected future events should be taken into
account when there is 'sufficient objective evidence' available suggesting that the future event
will occur.

Example-3 Future events

A company owns a number of nuclear plants. The company is presently obliged to
dismantle one of these nuclear plants in 3 years’ time.

The last nuclear plant dismantled by the company cost Rs. 1,000,000 to dismantle, but
the company expects to dismantle this nuclear plant, if using the same technology, at a
slightly reduced cost of Rs. 800,000 due to the increased experienced. There is,
however, a chance that completely new technology may be available at the time of
dismantling which could lead to a further Rs. 200,000 cost saving.

Required:
Discuss the measurement of the provision.

Note-4
Gains on disposals of Assets: [Para 51]/ setoff Adjustment will not be allowed in IAS-37
When an obligation involves the sale of an entity's assets and the sale thereof is expected to
result in a gain, this gain should not be included in the calculation of the provision since this
would reduce the provision, which would not be consider prudent.

Example-4
New legislation means that U LTD must dismantle its nuclear plant in a year's time. The
dismantling is estimated to cost Rs. 300,000 but U Ltd also expects to earn income from the sale
of scrap metal from plant of Rs. 100,000. The effects of discounting are expected to be
immaterial.
Required:
Process the required journal entry to raise the provision.
***Expected costs of dismantling (i.e. the Rs 100,000 expected Income is not offset against the expected costs) Gain
will be recognized when it will be earned at the time of sale of scrap metal. (As per IAS-16)

Note-5
Practice Phase (Self Assessment)
Example 1 - Warranties
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms
of the contract for sale the manufacturer undertakes to make good, by repair or replacement,
manufacturing defects that become apparent within three years from the date of sale. On past
experience, it is probable (i.e. more likely than not , > than 50%) that there will be some claims
under the warranties.
Present obligation as a result of a past obligating event – The obligating event is the sale of the
product with a warranty, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement – Probable for the warranties
as a whole.
Conclusion – A provision is recognized for the best estimate of the costs of making good under
the warranty products sold before the end of the reporting period.
Example-2 Contaminated land – legislation virtually certain to be enacted
An entity in the oil industry causes contamination but cleans up only when required to do so under
the laws of the particular country in which it operates. One country in which it operates has had
no legislation requiring cleaning up, and the entity has been contaminating land in that country for
several years. At 31 December 20X0 it is virtually certain that a draft law requiring a clean-up of
land already contaminated will be enacted shortly after the year-end.
Present obligation as a result of a past obligating event – The obligating event is the contamination
of the land because of the virtual certainty of legislation requiring cleaning up.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognized for the best estimate of the costs of the clean-up.
Example-3 Contaminated land and constructive obligation
An entity in the oil industry causes contamination and operates in a country where there is no
environmental legislation. However, the entity has a widely published environmental policy in
which it undertakes to clean up all contamination that it causes. The entity has a record of honoring
this published policy.
Present obligation as a result of a past obligating event – The obligating event is the contamination
of the land, which gives rise to a constructive obligation because the conduct of the entity has
created a valid expectation on the part of those affected by it that the entity will clean up
contamination.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognized for the best estimate of the costs of clean-up.
Example-4 – Offshore Oilfield
An entity operates an offshore oilfield where its licensing agreement(**legal obligation) requires
it to remove the oil rig at the end of production and restore the seabed. Ninety per cent of the
eventual costs relate to the removal of the oil rig and restoration of damage caused by building it,
and 10 per cent arise through the extraction of oil. At the end of the reporting period, the rig has
been constructed but no oil has been extracted.
Present obligation as a result of a past obligating event – The construction of the oil rig creates a
legal obligation under the terms of the license to remove the rig and restore the seabed and is thus
an obligating event. At the end of the reporting period, however, there is no obligation to rectify
the damage that will be caused by extraction of the oil.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognized for the best estimate of ninety per cent of the eventual
costs that relate to the removal of the oil rig and restoration of damage caused by building it. These
costs are included as part of the cost of the oil rig. The 10 per cent of costs that arise through the
extraction of oil are recognized as a liability only when the oil is extracted.
Example-5 Refunds policy
A retail store has a policy of refunding purchases by dissatisfied customers, even though it is
under no legal obligation to do so. Its policy of making refunds is generally known.
Present obligation as a result of a past obligating event – The obligating event is the sale of the
product, which gives rise to a constructive obligation because the conduct of the store has created
a valid expectation on the part of its customers that the store will refund purchases.
An outflow of resources embodying economic benefits in settlement – Probable, a proportion of
goods are returned for refund
Conclusion – A provision is recognized for the best estimate of the costs of refunds.
Example-6 **Closure of a division – no implementation before end of the reporting period
On 12 December 20X0 the board of an entity decided to close down a division. Before the end of
the reporting period (31 December 20X0) the decision was not communicated to any of those
affected and no other steps were taken to implement the decision.
Present obligation as a result of a past obligating event – There has been no obligating event and
so there is no obligation(either legal or constructive).
Conclusion – No provision is recognized.
Example-7 ***Closure of a division – communication/implementation before end of the
reporting period
On 12 December 20X0, the board of an entity decided to close down a division making a particular
product. On 20 December 20X0 a detailed plan for closing down the division was agreed by the
board; letters were sent to customers warning them to seek an alternative source of supply and
redundancy notices were sent to the staff of the division.
Present obligation as a result of a past obligating event – The obligating event is the communication
of the decision to the customers and employees, which gives rise to a constructive obligation from
that date, because it creates a valid expectation that the division will be closed.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognized at 31 December 20X0 for the best estimate of the costs
of closing the division.
Example-8 - Legal requirement to fit smoke filters
Under new legislation, an entity is required to fit smoke filters to its factories by 30 June 20X1.
The entity has not fitted the smoke filters.
(a) At 31 December 20X0, the end of the reporting period.
Present obligation as a result of a past obligating event – There is no obligation because there is
no obligating event either for the costs of fitting smoke filters or for fines under the legislation.
Conclusion – No provision is recognized for the cost of fitting the smoke filters.

(b) At 31 December 20X1, the end of the reporting period

Present obligation as a result of a past obligating event – There is still no obligation for the costs
of fitting smoke filters because no obligating event has occurred (the fitting of the filters).
However, an obligation might arise to pay fines or penalties under the legislation because the
obligating event has occurred (the non-compliant operation of the factory).
An outflow of resources embodying economic benefits in settlement – Assessment of probability
of incurring fines and penalties by non-compliant operation depends on the details of the
legislation and the stringency of the enforcement regime.
Conclusion – No provision is recognized for the costs of fitting smoke filters. However, a
provision is recognized for the best estimate of any fines and penalties that are more likely than
not to be imposed.
Example-8 - Staff retraining as a result of changes in the income tax system
The government introduces a number of changes to the income tax system. As a result of these
changes, an entity in the financial services sector will need to retrain a large proportion of its
administrative and sales workforce in order to ensure continued compliance with financial services
regulation. At the end of the reporting period, no retraining of staff has taken place.
Present obligation as a result of a past obligating event – There is no obligation because no
obligating event (retraining) has taken place.
Conclusion – No provision is recognized.
Example-9 - A court case
After a wedding in 20X0, ten people died, possibly as a result of food poisoning from products
sold by the entity. Legal proceedings are started seeking damages from the entity but it disputes
liability. Up to the date of authorization of the financial statements for the year to 31 December
20X0 for issue, the entity’s lawyers advise that it is probable that the entity will not be found liable.
However, when the entity prepares the financial statements for the year to 31 December 20X1, its
lawyers advise that, owing to developments in the case, it is probable that the entity will be found
liable.
(a) At 31 December 20X0
Present obligation as a result of a past obligating event – On the basis of the evidence available
when the financial statements were approved, there is no obligation as a result of past events.
Conclusion – No provision is recognized. The matter is disclosed as a contingent liability
unless the probability of any outflow is regarded as remote.
(b) At 31 December 20X1
Present obligation as a result of a past obligating event – On the basis of the evidence available,
there is a present obligation.
An outflow of resources embodying economic benefits in settlement – Probable.
Conclusion – A provision is recognized for the best estimate of the amount to settle the
obligation.
Example-10- Repairs and maintenance
Some assets require, in addition to routine maintenance, substantial expenditure every few years
for major refits or refurbishment and the replacement of major components. IAS 16 Property, Plant
and Equipment gives guidance on allocating expenditure on an asset to its component parts where
these components have different useful lives or provide benefits in a different pattern.
A) - Refurbishment costs – no legislative requirement
A furnace has a lining that needs to be replaced every five years for technical reasons. At the
end of the reporting period, the lining has been in use for three years.
Present obligation as a result of a past obligating event – There is no present obligation.
Conclusion – No provision is recognized. The cost of replacing the lining is not recognized
because, at the end of the reporting period, no obligation to replace the lining exists
independently of the company’s future actions— even the intention to incur the expenditure
depends on the company deciding to continue operating the furnace or to replace the lining.
Instead of a provision being recognized, the depreciation of the lining takes account of its
consumption, i.e. it is depreciated over five years. The re-lining costs then incurred are
capitalized with the consumption of each new lining shown by depreciation over the
subsequent five years.
B) - Refurbishment costs – legislative requirement
An airline is required by law to overhaul its aircraft once every three years.
Present obligation as a result of a past obligating event – There is no present obligation.
Conclusion – No provision is recognized. The costs of overhauling aircraft are not recognized
as a provision for the same reasons as the cost of replacing the lining is not recognized as a
provision. Even a legal requirement to overhaul does not make the costs of overhaul a liability,
because no obligation exists to overhaul the aircraft independently of the entity’s future
actions—the entity could avoid the future expenditure by its future actions, for example by
selling the aircraft. Instead of a provision being recognized, the depreciation of the aircraft
takes account of the future incidence of maintenance costs, i.e. an amount equivalent to the
expected maintenance costs is depreciated over three years.